Stress Testing

The “Understanding Stress Testing” video reviews the concept of stress testing, risk capital, value at risk, asset liability management and capital adequacy applications for stress testing in just over 400 minutes (6 hours and change). The following topics are covered:

Course Prerequisites

Course Audience

The course is targeted at intermediate and advanced users and is aimed primarily at banking professionals who need to review stress testing material for work, professional review, audit or personal development as well as for individuals responsible for capital allocation, risk management and implementing the ICAAP framework within banks.

Course Guide

Here is the structure of the course.

Title

Duration

Session 1 – Introduction

18:42 mins

Session 2 – Stress Testing Capital

26:46 mins

Session 3 – Stress Testing Framework

20:04 mins

Session 4 – Introduction to Asset Liability Management (ALM)

33:15 mins

Session 5 – Interest Rate mismatch & ALM

21:51 mins

Session 6 – ALM reports and extensions

26:59 mins

Session 7 – Value at Risk

Theoretical Overview

36:06 mins

VaR Qualifications

23:39 mins

Calculating VaR for a single security using VCV and Historical Simulation approaches

44:52 mins

Extending the VaR model to a portfolio. Calculating portfolio VaR without a VCV matrix

33:00 mins

Value at risk for Fixed income securities – Rate and Price VaR; Delta and Full Valuation approaches

Session One – Introduction

Regulators and shareholders are very interested in the margin of safety an organization should maintain. They are also aware that the right time to develop and test a strategy for managing and handling crisis is when operating conditions are normal and everyone can think clearly. Therefore in addition to identify the threshold of failure, stress testing also serves as a tool for testing reactions and responses to crisis before it occurs.

View a sample of session one

Session Two – Stress Testing Capital

We introduce the concept of different types of capital

Operate under normal conditions – aka operating capital

Operate under stressed conditions – aka risk capital

Operate under extreme conditions – aka signaling capital

There is a fine line between (b) and (c) and banking regulation and capital requirements are a non-stop battle between shareholders interpretation of how much capital is needed to survive the occasional hiccups and the regulatory understanding of the amount of capital a bank should carry on its balance sheet before it should be allowed to solicit deposits from customers.

We illustrate this with an example by looking at a position in Gold to show how stress testing ranges can be calculated using tools like value at risk, analyst expectations and worst case price history.

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Session Three – Stress Testing Framework

To create a viable stress testing framework we need the following elements

Pool of Metrics – elements or items that need to be measured

Benchmark value for metrics – ranges and threshold for metrics being measured

Set of extreme scenarios or a extreme dataset – a collection of scenarios that will be used to test

Tests for stability – A definition of stability and a test

Tests for probability of survival

A list of core risk factors

An initial crisis management plan

A criteria for evaluating the crisis management plan

View a sample of session three

Besides reviewing the basic and static capital adequacy framework regulators are also keen on testing capital adequacy under a range of scenarios. Some static, some a replay of historical crisis and others that are a simulation of complex interactions between all the market factors that impact the balance sheet of a bank.

Session Four – Introduction to Asset Liability Management (ALM)

After covering market (price) risk and credit risk, it is now time to take a look at Interest Rate Risk or Maturity Mismatch risk. Before we move on to the topic of bank capital adequacy it is important that we have a good grip on what drives Interest Rate Mismatch and Liquidity risk at a bank.We use Asset Liability Management as a tool to measure interest rate exposure and introduce the concept of maturity mismatch at a high level. This is quickly followed by an introduction to a simplified ALM framework that we will use as a foundation for the ALM stress testing report we will use in later sessions.

View a sample of session four

Session Five: Asset Liability Management (ALM)

We continue with more core definitions and introduce the primary questions an ALM framework is expected to answer covering both shareholder value and interest income sensitivity. Starting with duration and convexity we introduce the concept of Asset Sensitivity and Liability Sensitivity before walking through the core steps required for building an ALM model.

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Session Six: Asset Liability Management (ALM) Reports

In our last and final session on ALM, we introduce and walk through the Maturity and Rate GAP reports and use them to build and introduce the Earnings at Risk and Market Value of Equity at Risk reports. The session uses an Excel based template to walk participants through the 4 report format, their usage and applications.

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Session Seven – Calculating Value at Risk

a. Theoretical Overview

We take a detailed look at Value at Risk, VaR. We consider its various definitions and the questions that it may be used to answer. We see how the tool may be extended from its traditional market risk application to other applications such as margin management and profitability calculations. We consider how VaR is used to estimate capital for capital allocation purposes, marginal capital needed for additional investments made, to make comparisons of risk measures over time. We look at the general step-by-step process followed for calculating VaR and an introduction on the difference and uses between Rate VaR and Price VaR for calculating risk on Fixed Income securities.

View a sample of session one

b. VaR Qualifications

In this session we continue with our discussion of Value at Risk, VaR, starting with the difference between Price and Rate VaR. We move onto another VaR Case study which looks at the determination of VaR using the historical simulation approach. Next we review in detail the processes behind the calculation of each of the three VaR methods, issues with each method and comparisons between them. We see how the calculation is impacted for a change in the liquidation or holding period assumption. Lastly we look at Nicholas Nassim Talebs views on VaR in particular his rules for risk management.

View a sample of session two

c. Calculating VaR for a single security using VCV and Historical Simulation approaches

A detailed look at Value at Risk, VaR. We consider its various definitions and the questions that it may be used to answer. We see how the tool may be extended from its traditional market risk application to other applications such as margin management and profitability calculations. We consider how VaR is used to estimate capital for capital allocation purposes, marginal capital needed for additional investments made, to make comparisons of risk measures over time. We look at the general step-by-step process followed for calculating VaR and an introduction on the difference and uses between Rate VaR and Price VaR for calculating risk on Fixed Income securities.

View a sample of session three

d. Extending the VaR model to a portfolio. Calculating portfolio VaR without a VCV matrix

We extend the earlier discussion regarding VaR calculation for currencies to commodities. We then demonstrate how to calculate Value at Risk for a portfolio of securities using both the Variance Covariance (VCV) approach as well as the Historical Simulation Approach. We use a short cut method for the VCV approach that bypasses the need to construct a VCV matrix. However we also cross check the results from this short cut method with those obtained from the matrix method. During this course we demonstrate the use of EXCEL’s in-built TRANSPOSE and MMULT functions.

View a sample of session four

e. Value at risk for Fixed income securities – Rate and Price VaR; Delta and Full Valuation approaches

We consider its various definitions and the questions that it may be used to answer. We see how the tool may be extended from its traditional market risk application to other applications such as margin management and profitability calculations. We consider how VaR is used to estimate capital for capital allocation purposes, marginal capital needed for additional investments made, to make comparisons of risk measures over time. We look at the general step-by-step process followed for calculating VaR and an introduction on the difference and uses between Rate VaR and Price VaR for calculating risk on Fixed Income securities.

View a sample of session five

Session Eight: Capital – Learning to work with capital

we discuss the definitions & types of capital and the shift in paradigm in recent years with regard to capital attribution. We look at how a risk framework may be built around capital and consider an example of how to differentiate between regulatory & economic capital. We consider the structure for building a capital management/ attribution model, developing a risk policy with a focus on capital attribution and risk appetite. Review types of risk for which capital is assessed and the question of capital aggregation. A look at an ICAAP model & framework and review the limits management process of a capital protection framework presenting an overview of the link between transaction and expectation driven limits, a process linking VaR & VaR based limits to Stop Loss and Capital.

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Session Nine: Introduction to Capital Adequacy

In our refresher on capital adequacy, we review the origins of capital adequacy regulation and margin of safety in banks starting with Regulation Q and the evolution of the Basel I and Basel II standards over the last 30 years.

Session Eleven: Understanding Duration & Convexity

We review duration and convexity; the alternative definition of convexity and its importance to the risk management process, the relationship between options, convexity and volatility.

View a sample of session eleven

Stress Testing Crash Course: Instructor

Facilitator profile

Jawwad Ahmed Farid is a Fellow Society of Actuaries (Chicago), a MBA from Columbia Business School (New York City) and a computer science graduate. During the last 19 years, he has worked as a consultant in North America, Pakistan and the United Kingdom with a number of blue chip clients including Hartford Life, Aegon, American General, Goldman Sachs, ING, Manu Life, Merrill Lynch, Met Life, Sun America, Nationwide, Sumitomo Mitsui Bank, Sun Life of Canada, Pacific Life, AllState, Fidelity Investments, Transamerica, Skandia, GE Financial Assurance, AXA Equitable and Washington Mutual Bank.

Jawwad’s core areas of expertise include Asset/Risk Management, Investments, Product Development & the Financial Services Back Office. Jawwad blends a rare combination of risk management, information systems, international standards, business and product development skill set side by side with his actuarial expertise.

He is the author of three books on Entrepreneurship (Reboot), Commodity Markets (Understanding Commodities Risk) and Risk Management (Risk Application and Frameworks).

As an investment advisor Jawwad has advised a 3 billion US$ dollar life insurance fund in Pakistan on allocation and bid patterns for 10, 20 and 30 year bonds, a 30 million dollar Middle East fund on their ALM mismatch and fixed income strategy, a 10 million dollar fund on asset allocation and equity market timing in Pakistan. He has also worked with the securities regulator on assessing the state of the corporate bond market as well as issued valuation opinions on cross currency swaps, interest rate swaps, caps, floors, participating forwards and contingent liabilities for Exchange Guarantee Funds in the region.

Jawwad has worked directly as a founder, founding team member, mentor and advisor at multiple startups including two green field life insurance companies, multiple technology product businesses, financial services consulting operations, risk and investment advisory businesses, product focused distribution as well as micro insurance, micro pensions and micro finance startups.

In addition to being a PASHA CEC member and Treasurer he has also served as a judge at the Asia Pacific ICT Awards in Macau, Singapore, Kula Lumpur and Jakarta as well as at PASHA ICT Award in 2006, 2007, 2008, 2009, 2010. He currently serves as member of the oversight board for the PASHA Social Innovation Fund.

The Alchemy / LCF Stress Testing Workshop can be delivered in live instructor led sessions as well as a cost effective online formats for treasury managers, risk professionals, senior leadership teams as well high value clients and customers.

If you liked this course, please also see the quarterly and annual subscription plans for continuing and professional education needs of actuaries, accountants, members of GARP, PRMIA, AICPA and others.